November 21, 2012

A Fiscal Cliff Compromise That Could Work For Everyone

Two entrenched positions define the revenue dimension of the fiscal cliff debate—Republicans’ opposition to rate increases, and President Obama’s longstanding vow not to raise taxes on families making $250,000 per year or less. Each side has reasonable if not completely compelling arguments in favor of its position. Republicans say that a suitably reformed tax code would be more pro-growth than what we have now; Democrats counter that the changes in the code since 2000 have exacerbated the widening gap between the wealthy and the rest of us.

It is possible that one side will feel compelled to surrender—to yield on its core commitment. That’s what Minority Leader Nancy Pelosi and many other Democrats believe: the public’s support for higher taxes on the wealthy will force Republicans to allow rates to rise for the top 2 percent of taxpayers. Maybe so. But if neither side yields and we go over the cliff, both sides lose from their own perspectives. As of January 3, taxes go up on what President Obama capaciously defines as the middle class, and the tax code is less pro-growth from the supply-side point of view.

To be sure, no one believes that non-agreement by December 31 would be the end of the story. After a period of finger-pointing, discussions would resume. But equally, no one knows how the failure to reach agreement before the end of 2012 would affect the dynamics of the negotiations. We can be reasonably sure, however, that national and global markets would react adversely and that businesses, which are already retreating from planned investments in new plant and equipment, would become even more uncertain and risk-averse.

Two years ago, I co-authored a ten-year budget plan designed to stabilize the national debt as a share of GDP while preserving progressive commitments. To meet these goals, we found that the United States will need revenues between 20 and 21 percent as a share of GDP (the level reached at the end of the Clinton administration). This brute fact leaves us with a choice: we could try to meet needed revenue targets by raising rates within the existing tax code or by achieving fundamental reform that simplifies the code, puts all sources of income on a more equal footing, and cuts back on tax expenditures that contribute to neither growth nor fairness. (I’d be happy to throw a carbon tax into the mix as well.)

But we can’t reach that kind of solution—or any kind of comprehensive long-term agreement—between now and December 31. As we learned in 1985-86, tax reform is a long, complex, contentious process, even when all parties are working within the same basic framework. So we need an interim solution that meets the minimum requirements of both sides and sets the stage for broader negotiations next year.

Here’s one version of such a deal. As a point of departure, both sides would accept a cap of $50,000 on itemized deductions. (According to the Tax Policy Center, individuals making more than $200,000 would bear almost all the increased burden.) In addition, Republicans would agree to raise the tax rates on dividends and capital gains, narrowing the gap between today’s very low rates and those that prevailed pursuant to the Reagan tax reform of 1986.In return, President Obama and the Democrats would agree to leave the rates on earned income at current levels. Because this revenue down-payment would be part of a broader framework agreement, it would expire on the date that the broader negotiations included in that agreement are required to reach a conclusion.

Under this scenario, everybody gets something: Republicans can tell their supporters that they held the line on top rates, Democrats can tell their supporters that they increased the tax burden on the wealthiest Americans while holding everyone else harmless, and President Obama can say that he honored his pledge not to sign another extension of the Bush tax cuts.

No doubt many Democrats will say: We won the election, and the Republicans are just wrong, so why shouldn’t we force them to capitulate? That viscerally attractive line of argument overlooks an inconvenient fact: the Republicans retained control of the House of Representatives by a margin not much diminished from the high tide of 2010, and they think their odds of repeating that result in the next mid-term election are pretty good. And besides, they say, they speak for the 48 percent of the country that didn’t vote for Obama. If no deal can work without their assent, why should they yield?

Democrats believe, with some justification, that if going for broke fails, the public will blame the Republicans for continued gridlock and rancor. But wouldn’t it be better for the President and the country to make real and visible progress toward solving our problems?